Investment style has a critical effect on performance, yet rarely receives the attention it deserves. Where a fund manager adopts a strong bias in favour of either growth or value, it’s bound to influence his final returns. The effect has been particularly dramatic since the bursting of the dot.com bubble, with growth stocks falling completely out of fashion. There is no question that value investors have reaped the rewards, but all the signs suggest growth is now ready to make a comeback.

Distiguishing styles

By contrast, growth managers look for companies with above-average earnings and profits growth that they believe are not fully reflected in the share price. These stocks will normally have a high p/e ratio and low or zero dividend yield. Investing in a growth fund is usually more risky because companies on high valuations like this are vulnerable to any kind of setback

Most style-orientated fund managers develop their own unique stock selection criteria. For example, Harry Nimmo, who runs the successful Standard Life UK Smaller Companies fund, looks for higher growth stocks with solid business models.

“We have a specific growth style and use a screening process that picks up on eight separate factors to identify suitable stocks,” he says. “These include growth indicators such as price momentum, earnings momentum and directors’ deals, as well as valuation measures like the p/e ratio, divident yield and earnings per share growth.”

There are lots of ways of distinguishing value from growth but one of the simplest and most effective uses the dividend yield. This measures the level of income from a share and is simply calculated as the dividend divided by the share price. Essentially, a share with an above average yield is classified as a value investment, with the remainder categorised as growth.

The story so far

In the UK there are two indices based on dividend yields and these provide a useful measure of the performance of value and growth stocks. The FTSE 350 Higher and Lower Yield indices are calculated by ranking the largest 350 companies in the country according to their yields. Those with above-average payouts are then included in the former, with the remainder going into the latter.

The lists of constituent companies are rebalanced each year so that the indices continue to provide a good measure of value and growth. This also means that, as individual companies evolve, they can move from one style to the other. For example, many technology stocks have fallen so far from their peak in March 2000 that they are now being snapped up by value investors.

Between 1995 and 1999, value and growth behaved in a clear cyclical manner, with successive periods dominated by one and then the other but neither gaining an overall lead. The technology, media and telecommunications (TMT) bubble changed all that, however, and, by the peak of the markets in March 2000, these growth stocks had outperformed value by over 50 per cent. Since the market crash the situation has reversed, with value stocks coming back into vogue. Overall this more risk-averse style has now outperformed growth by some 40 per cent.

Paul Ilott, senior investment advisor at IFA Bates Investment Services, says that growth fell out of favour after the millennium and was sold down by investors as they switched into old economy value stocks.

“Investors who had been let down by growth stocks saw cash-generative businesses as more transparent and preferred the immediacy of dividend income,” he says. “These companies have now risen in price to such an extent that it can be difficult to distinguish between value and growth shares.”

The dominance of value over growth is not purely a UK phenomenon but applies internationally as well. Since 2001, the FTSE World Value index has outperformed the equivalent growth measure by around 35 per cent. These indices use nine different measures to distinguish value from growth and cover all the major developed and emerging economies.

What drives value and growth

Julian Sutton, Portfolio Manager at Schroders’ Multi-Manager team, says that, in the late 1990s, growth stocks became massively overvalued as investors assumed they could maintain their early-stage growth rates indefinitely.

“As history now shows, this proved not to be the case, and the period after March 2000 was characterised by a number of high-profile downgrades in the TMT sectors, which led to a material de-rating and underperformance relative to old economy value stocks,” he says.

The second leg of the value revival was driven by lower interest rates following 9/11, which laid the foundation for a synchronised recovery in the global economy.

“Improved economic activity was just the tonic for cyclical stocks, particularly after March 2003, which in turn provided a boost for value indices as they exhibit more cyclicality than growth indices,” says Sutton.

Nimmo agrees with this cyclical view of value and growth, and says value performs best in the early parts of the economic cycle after a recession.

“It’s not until the mid-part of the cycle that investors start to look for companies that can grow even when there’s no growth in the economy itself,” he says. “We have now finished the recovery stage of the cycle and I expect to see growth start to take the lead as the economy slows down. That is not to say that the blue-sky stocks will do well, which is why I only look for good-quality growth companies.”

Time for growth

Sutton says that shifts in economic and monetary conditions, as well as relative valuations, are pointing to the return of a more favourable environment for growth stocks.

“We expect global growth to slow in the second half of the year and historically this has been beneficial for growth stocks,” he says. “The second factor in their favour is valuation. Investors are giving little credit to companies with superior growth prospects and in this context these stocks look relatively cheap.”

In a recent European fund trends survey, conducted by analysts Morningstar, 80 per cent of fund managers said that keeping a consistent investment style was important. In terms of performance, 57 per cent believed that growth-orientated funds would lead the way in 2006, while only 11 per cent preferred value.

Most investment groups offer a mix of different styles across their funds, but some organisations have distinct biases. For example, SocGen and the AXA Framlington UK team place the emphasis firmly on growth, whereas Invesco Perpetual and Franklin Templeton are more value orientated.

For many UK investors the value-versus-growth debate will determine whether they allocate resources to value areas like ‘Equity Income’ funds or the ‘All Companies’ growth sector.

“The tide is turning and growth managers are now finding better opportunities than they have for some time,” says Ilott. “UK Equity Income – the principal source of value – has done extremely well over the last five years, but investors may well find that the growth funds of the All Companies sector offer better prospects.”

By definition, Equity Income funds must provide a yield that is at least 10 per cent greater than that on the FTSE All-Share index. This limits the manager’s stock selection options since only around 150 of the 690 constituent shares actually meet this criterion. This is one reason why none of the Schroders’ multi-manager portfolios currently has any exposure to UK Equity Income funds. The other is because the management team think that value has had its day.

Tim Cockerill, head of research at IFA Rowan Capital Management, says there has been a compression of valuations, so a company that is growing has become a more attractive proposition.

“What came out of the stock market crash was a more pragmatic approach to stock selection with the focus on finding quality companies,” he says. “Careful stock selection is the key, although perhaps going forward we will see more growth companies falling into this category.”

Growth funds

The contrast in the performance of growth and value over the last six years could hardly be greater. Value stocks as measured by the FTSE 350 Higher Yield index have risen by 62 per cent, while during the same period the lower yield growth index has fallen by a fifth. Given the cyclical nature of these styles it is unlikely that such a trend will continue. This suggests that growth funds could pick up strongly and that past returns may not be a good guide to future performance.

“We have reached a turning point and I do not expect Equity Income and other value funds to do as well [in the future] as they have done,” says Ilott. “Investors may want to skew their portfolios in favour of growth, but they should retain some value and blend funds to give a good overall balance.”

According to Ilott, funds likely to prosper in a growth-orientated market include Schroder UK Alpha Plus. This has a fairly concentrated Large Cap portfolio although Richard Buxton, the manager, adopts a fairly pragmatic investment approach. Another likely to do well is Artemis UK Growth. The manager, Adrian Paterson, has recently been increasing his exposure to larger companies, as he believes that these are now attractively priced.

Away from the Large Cap arena Ilott suggests AXA Framlington UK Select Opportunities, which is more of a mid and small cap growth fund where the manager looks for growth at a reasonable price. This has more than doubled investors’ money over the last three years.

Cockerill instead picks out the AXA Framlington UK Small Companies fund, which has an even better performance record. He says that by their own admission, the company concentrates on looking for superior long-term growth opportunities. Cockerill also likes Old Mutual UK Select Smaller Companies. The manager, Dan Nickols, takes a top-down view to identifying which parts of the economy will do well and then looks for superior growth opportunities within those sectors. This approach has helped the fund to increase by 140 per cent in the last three years.

In terms of growth-styled investment trusts the options include: Scottish Mortgage, a total return fund managed by Baillie Gifford; Gartmore Smaller Companies; and the Throgmorton Trust, which also concentrates on the small-cap end of the market. The latter in particular has performed exceptionally well.

One alternative to these actively managed funds is to invest in pan-European value and growth exchange-traded funds (ETFs). These exchange-traded funds track the large cap DJ Euro STOXX Value and Growth indices and can be bought and sold like an ordinary share via a stockbroker. See www.ishares.net for more details.

Blend funds

Investors who would rather dodge the whole issue of value versus growth may prefer a more style-agnostic product. Blend funds, for example, allow the managers the freedom to pick a combination of the best value and growth stocks on the market. Of these, Ilott recommends either Rensburg Select Growth, which is managed by Mark Hall, or Merrill Lynch UK Dynamic. Both offer a good balance between value and growth and have delivered returns of over 90 per cent over the last three years.

Cockerill instead suggests F&C UK Opportunities, which he says does something that other funds don’t. Launched in December, the manager aims for long-term capital growth via the unusual approach of holding a concentrated portfolio of 25 equally weighted stocks.

Alternatively Cockerill recommends M&G UK Select. This is another focused portfolio where the manager, Mike Felton, has the freedom to aggressively exploit his high conviction ideas.

Investment trust managers who swap between the two styles include Nick Greenwood at iimia, who targets absolute returns by investing in other closed-end funds, and Andy Crossley at INVESCO English & International – a UK smaller companies fund that has performed exceptionally well.